Description

Company and Situation Background:

Prior to its 11/1/21 acquisition of GECAS, AER was the largest passenger aircraft lessor in the world. Through the deal, AER almost doubled the size of its passenger aircraft leasing business and acquired the largest aircraft engine and helicopter leasing business in the world. AER currently owns ~$60bn of lease assets, consisting of ~86% passenger aircraft, ~6% for both aircraft engines and helicopters, and ~2% freighter aircraft. AER’s passenger aircraft portfolio is skewed toward narrowbody aircraft (60% of passenger aircraft NBV) followed by widebody aircraft (39%) and regional / other aircraft (2%). The average age of AER’s passenger fleet is 7.2 years with “next generation” aircraft at 4.0 years (~67% of NBV) and 13.4 years for “current generation” aircraft (~33% of NBV).

On 3/10/21, AER announced its ~$30.7bn acquisition of GECAS (~$25bn of debt / ~$6bn of AER stock at ~$50 per AER share). Through the deal, AER shareholders would own 54% of the combined company with GE owning the other 46%. The purchase price prior to news of the deal leaking implied AER was acquiring GECAS at a discount to GAAP asset value (~$34.5bn). We believe this acquisition was highly opportunistic and value accretive to AER, as GE was looking to improve its balance sheet, unlock value through business simplification, and reduce exposure to the aviation industry, which while past the COVID crisis peak, remained challenged. The merger proxy indicates that AER and GE directly negotiated this deal (no other bidders), and that AER and GE discussed a combination during 2020 before agreeing to the transaction’s structure on 1/20/21. At that time, COVID vaccine rollup was just starting, and the aviation industry’s recovery remained extremely uncertain (airline traffic, as measured by RPKs, was down ~72% vs. ‘19) and AER’s share price was only $42, valuing GECS at $29.7bn.

We believe that AER’s current share price implies that the company will destroy shareholder and asset value over the long-term and is being held back by (1) recent bank failures, which do not impact AER in any meaningful fashion, and (2) GE ownership overhang (GE still owns ~34% of AER and is planning to sell-down its stake over time). We couldn’t disagree more with the premise that AER will destroy value over the LT, as there are multiple reasons why we believe that the GAAP accounting mark of AER’s current portfolio materially understates the fair market value of its fleet and other assets. We also have very high confidence that AER’s management team, whose track record of increasing per share value over the long-term is exceptional, will use this mispricing in AER’s shares to create further LT shareholder value via accretive share repurchases.

Intrinsic Value / Price Target:

• Price targets only reflects AER’s book as of Q4 ’22. We believe that this is a very conservative approach to valuation, as it does not give AER credit for future value creation through future accumulated earnings and/or value-accretive repurchases (we believe that the fair value of AER’s fleet > its book value).

• Price targets only gives AER credit for GECAS assets value appreciation since deal close; however, before the GECAS deal closed AER’s gain on sale margins were 10% - 15%, which suggests that legacy AER’s accounting marks were conservative and in-the-money despite COVID’s negative impact on aircraft values. 

Key Thesis Points – Summary:

• AER is trading at a significant discount to historical multiples outside of crisis periods (GFC / COVID).

• Our work suggests that AER’s GAAP-book marks significantly understate actual fleet and other asset value.

  • We estimate that purchase accounting marked GECAS’ fleet assets at a ~18% discount to stated book.

    • At a minimum, we know that new aircraft values have appreciated LSD% - MSD% since closing date.

  • AER’s books assign no value to potential insurance recovery on the $2.7bn write-off of planes stuck in Russia.

  • Continued tightening of the commercial aircraft market due to strong demand (further traffic recovery) and constrained supply (Boeing and Airbus struggling to ramp production), should bode well for aircraft values.

  • Inflation has caused aircraft replacement cost to increase.

• We believe the recent softness in AER’s share price is due to concerns around bank failures. While AER relies on the capital markets to fund its future order book, we believe its balance sheet and access to capital has never been better.

  • AER’s leverage is at its lowest point in its history despite COVID, the GECAS transaction, and Russia write-off.

  • AER’s access to capital has improved following recent upgrades by all 3 ratings agencies.

    • For the first time ever, AER is IG rated across all agencies (Moody’s: Baa2, S&P: BBB, Fitch: BBB).

Key Thesis Points – Details:

• AER is trading at a significant discount to historical multiples outside of crisis periods (GFC / COVID).

  • From ‘15 – ’19 (outside of GFC/COVID crises), AER has traded at an average of ~1.0x EV / tangible invested capital (“Tang. IC”). At the current ~$55 price, AER is trading at ~0.96x EV / tangible invested capital.

• Purchase accounting caused AER to mark GECAS’ fleet at a large discount to GECAS’ pre-deal book values.

  • We estimate that purchase accounting caused GECAS’ flight equipment + maintenance rights to be marked at an 18% discount to stated book values after making a ~$3.1bn adjustment to harmonize GECAS’ useful life standards (aircraft: 20 years / helicopters: 15 years) with AER’s (aircraft: 25 years / helicopters: 30 years).

    • This markdown comes even though GECAS took specific COVID impairments of ~$570mm (1.9% of NBV) during 2020, which compares to AER’s ~$970mm of COVID impairments (2.6% of NBV).

    • AER uses industry standard useful life assumptions, while GECAS’ much shorter aircraft useful life meant that its passenger fleet NBV was materially lower (~$3.1bn) than industry / AER standards.

      • Per the merger filings, AER brought over GECAS’ fleet using AER’s useful life assumptions, so we need to make the adjustment to make the discount calculation apples-to-apples.

• AER’s gain on sale rate since the deal closed (ex. Q1 ’22), has averaged ~15% (see bar chart + table below).

  • AER’s sales volume has increased since the deal closed, so it has been selling aircraft out of GECAS’ portfolio, which further supports that the GECAS mark is conservative.

  • AER generated only a 0.7% gain rate on sales in Q1 ’22 as AER was selling GECAS aircraft that had been brought over under held-for-sale accounting, which meant that the mark for these aircraft equaled the contractual sale price, not the “fair value” mark as determined by purchase accounting.

    • AER’s CFO responded with the following when asked why the Q1 ‘22 gain rate was only 0.7%:

"The gain on sale was…lower in [Q1 ’22 because] there were sales of around $800mm worth of legacy GECAS aircraft that [were] pending when the acquisition closed in November. These were aircraft that GECAS had contracted to sell, but the sales hadn't closed when we [closed] the acquisition. Since then, they have started to close. The average gain on those sales was >10%. But in purchase accounting, we had to mark those assets at the sale price, which is the price that the buyer is paying us. We won't be booking any gains on those assets because they just come on to our books at the higher value. For [Q1 ‘22]…we would have had $20 million more of gains if we didn't have that purchase accounting effect. And I should say all of those sales will be done by the end of the year. So that has an impact on the gain on sale margin that we're using. Basically, we haven't assumed any -- much in terms of gains on sale in this forecast. But we would expect on the other assets that weren't contracted before the acquisition, we'd expect to have healthy gains as we have in the past.” – Pete Juhas 5/17/22

• Values for new aircraft (also a proxy for used values) are up MSD% - LDD% since the deal closed (11/1/22).

• We believe AER will recover a portion of the ~$2.7bn of write-off of aircraft and engines stranded in Russia.

  • AER has filed ~$3.5bn of claims against its insurance providers seeking to trigger war and/or all-risk clauses.

    • Insurers are countering by arguing that the war clauses haven’t been triggered because the aircraft haven’t been destroyed, and thus the lessors have not been “permanently deprived” of their assets.

    • Lessors will likely argue that (1) the war and Russia’s laws nationalizing foreign assets, has directly caused the loss of their planes and (2) the EU and US have shown no willingness to ease sanctions, especially for anything that could remotely aid the Russian defense industry.

    • Insurance rates for aircraft placed in / leased to higher-war risk countries have increased substantially post-invasion, so insurers are now getting better economics without having to pay for the losses.

  • Even if this takes until 12/31/27 (~4.7 years and a 10% discount rate) to resolve at a 50% recovery of the write-off ($2.7bn), not the claim amount ($3.5bn), the after-tax NPV of the proceeds is ~$730mm today.

    • At 75% / 25% recovery rates, the after-tax NPV of the proceeds is $1.1bn / $365mm, respectively.

• Continued tightening of the commercial aircraft market due to strong demand (further traffic recovery) and constrained supply (Boeing and Airbus struggling to ramp production), should bode well for aircraft values.

  • Despite the current oversupplied state, aircraft values have been increasing.

  • If the OEMs hit their delivery forecasts (unlikely given how long dated and highly specialized the commercial aerospace supply chain is), then the market will likely only be moderately oversupplied.

  • AER’s CEO (Angus Kelly), who is far from a promotional CEO, has sounded extremely bullish on the aircraft supply and demand situation, particularly on widebodies as the following quote demonstrates:

“Consumers continue to prioritize travel well after restrictions are lifted and this will be no different in China. As a result, the Chinese airlines are all planning to ramp up capacity. We believe this will further exacerbate the supply/demand imbalance for aircraft and engines pushing lease rates higher…This will be particularly acute on the widebody side as the combination of severely restricted new aircraft production, continued traffic growth and the retirement and cargo conversion of many widebody aircraft that took place during COVID puts a premium on aircraft that are available today and AerCap is well positioned to address this opportunity. We have spoken before about the shortages on the narrowbody side where production cuts due to groundings, COVID and supply chain issues have [meant that] there are approximately 1,800 fewer narrowbody aircraft built today compared to the production run rate in 2018. This is equivalent to approximately 11% of the 16,000 or so narrowbody aircraft in operation at that time. On the widebody side, these reductions have been even more acute. Production rates for new technology aircraft such as the 787, the 330neo and the A350 are also well below expectations.

“Airbus was targeting 5 A330neos per month in 2019 and delivered less than 3 per month in 2022. They were targeting 10 A350s per month in 2019 and delivered only 5 per month in 2022. Boeing [was] targeting 14 787s per month in ‘19 and delivered less than 3 a month in ‘22 with more than 80% of these coming from storage. This has resulted in approximately 740 fewer widebody aircraft built since 2019, a 15% reduction relative to the 5,000 or so widebody aircraft that were in service at the time. That's equivalent to almost 2 full years of normal production. So how are we capitalizing on this opportunity? The best example I can give you is that since the start of 2022, AerCap has completed nearly 100 widebody transactions, which…is possibly more than the rest of the aircraft leasing industry combined. We are seeing broad-based demand and we expect this to be sustained by continued traffic growth and low production rates for widebody aircraft. We believe that the issues affecting aircraft production are likely to persist for several years resulting in strong demand and upward pressure on lease rates and values for the foreseeable future.” – Angus Kelly, AER CEO, 3/2/23

Risks:

• Aircraft values + duration mismatch

  • Aircraft values are strong today, but if Boeing and Airbus boost production to their targeted ‘25 rates on time, then the aircraft markets will likely be oversupplied in our base-case travel recovery scenario.

  • AER’s $24bn order book will deliver between now and 2027.

    • 93% of AER’s order book through 2024 (~$14bn / ~60% of total order book) is placed.

    • AER’s order book represents ~40% of its current fleet NBV.

      • By contrast, Air Lease’s order book is ~$25.5bn with ~$23bn delivering through 2023.

      • AL’s order book delivering through 2027 represents a whopping ~94% of its current fleet NBV.

  • All else equal rising interest rates should hurt aircraft values.

    • But inflation has increased aircraft replacement cost, while AER’s fleet is marked at historical cost.

• Risk of NIM compression from rising rates due to duration mismatch.

  • AER has more debt maturing (~$30.6bn) in the next 5 years than it has aircraft coming off lease (~$8.6bn).

    • ~77% of this debt maturing is fixed rate debt with ~3% rates.

  • ~94% of AER’s debt in 2023 is effectively fixed rate (fixed + variable rate subject to interest rate caps / swaps).

Catalyst

Continued strong gains on sale and repurchases